The Indian retail sector, which has been hammered for the past couple of years, is expected to see signs of stability emerging amid persistent weak demand drivers and weak credit metrics of the dominant players.

Demand Stable despite Weak Drivers: According to a report by India Ratings, a part of Fitch Group, residential demand showed signs of stability in 2012, with yoy growth in home loans from banks showing an uptrend from May 2012. However, the sales of large players declined marginally in 2012. Economic weakness continued with the associated apprehension of employee downsizing and salary freezes, which adversely affected consumer sentiments. Persistence of adverse sentiments, high inflation and high interest rates which reduce affordability, coupled with high property prices, continue to hinder any improvement in demand.

Commercial demand will be hit by subdued job growth in the IT sector, where average quarterly net headcount addition in 2012 was around 28 percent-32 percent, lower than that in the previous two years. Demand for retail space is likely to be muted in the near term.

Stable Margins despite High Costs: EBITDA margins, which steadily declined to 30 percent in FY12 from about 55 percent in FY08, remained at around that level during 2012. That this was possible despite increases in construction costs, signals a potential return of stability.

Liquidity Pressures Ease: In FY12, real estate companies generated positive FCF and the trend continued into H1FY13. Apart from stable demand, other efforts to improve liquidity included strategies like monetisation of land and non-core assets, exercising prudence in new launches and adopting the JV route to developing projects.

Leverage to Stay High: Although companies are continuing their debt reduction efforts, the lower level of profitability at which the industry seems to be stabilising now will keep financial leverage (gross debt/EBITDA) at elevated levels of around 6.5x in the short to medium term. To achieve a significant improvement in leverage, companies will need to rely less on debt financing and focus on buyer advances and internal accruals – a strategy which can only be adopted if there is an improvement in demand.

Funding Options Limited: Banks’ exposure to the commercial real estate sector increased by only 1.7 percent during the first 11 months of 2012. Private equity inflow into the sector has been moderate. The limited funding options imply companies’ continued dependence on operational cash flows for funding growth and debt servicing. Commercial real estate developers, especially those with cash flow visibility through lease rentals, continue to have better credit profiles.

What Could Change the Outlook: Continuation of positive free cash flow generation, stability in EBITDA margins and improvement in demand could change the sector outlook to stable. Banks’ total exposure to the housing sector had always been increasing on a yoy basis. However, the downtrend in growth seen till May 2012 reflected a slowing down of disbursements. In fact, trailing 12-month disbursements (monthly disbursements calculated by taking the difference between month-end exposures and adding 1/120 of previous month’s outstanding to account for repayments) actually declined during the first few months of 2012 and started picking up only in May 2012. Its steady increase since then indicates a return of growth in the residential housing sector. However, large real estate companies show a declining trend in revenue; For 12 months ended September 2012, revenue was 8 percent lower than that observed in the 12 months ended September 2011. The prices during this period however remain firm in most cities. This indicates that demand is shifting in favour of lower ticket size housing, either affordable housing in tier 1 cities or new developments in tier 2 cities.

Commercial and Retail Demand to be Slow: India Ratings expects demand for commercial space to remain sluggish, till the IT sector revives. Given the economic slowdown, demand for retail space will also be low. Demand for commercial space is driven largely by the IT/ITeS sector, which is experiencing a slowdown in hiring. Average quarterly net hiring in major IT companies (aggregate data for Infosys Ltd., Tata Consultancy Services Ltd., Wipro Ltd., HCL Technologies Ltd., Tech Mahindra Ltd., Mindtree Ltd. and Cognizant Technology Solutions) at around 21,000 in 2012 was 32 percent lower than in 2011 and 28 percent lower than in 2010.

Demand Drivers Continue to be Weak: Economic growth has been progressively weak. The GDP growth for the past two to three quarters has been hovering around 5.3 percent-5.5 percent, compared with the 7 percent-8 percent growth achieved from June 2010 to June 2011. Inflation and interest rates continue to be high, with CPI inflation being 9.8 percent on an average from June-November 2012.

Only a handful of banks have responded to the Reserve Bank of India’s (RBI) 50bps reduction in repo rates in April 2012, by reducing their bank rate marginally by 25bps. Economic weakness fosters fear about job losses and salary freezes; and in such a scenario, high property prices and elevated interest rates, resulting in high EMIs, encourage postponement of purchase decisions.

Margins Stabilise Despite Cost Pressures: EBITDA margin during January-September 2012 has stabilised at the 2011 level of 30 percent, from highs of 50 percent-60 percent in 2007 and 2008. This happened despite continuing cost pressures, as companies were able to pass on cost increases to consumers, resulting in firm property prices.

From January-September 2012, average yoy growth in steel prices was 17 percent and that of cement was 10 percent (Source: CMIE). The National Rural Employment Guarantee Scheme (NREGS) will keep labour supply constrained, while wages being inflation linked will further add to costs.

Leverage to Remain Elevated Despite Debt Reduction Efforts: In September 2012, aggregate outstanding debt for the large real estate companies presented here was 7 percent lower than that in September 2011. Companies have been making a conscious effort to reduce debt, at times through selling off non-core assets. To illustrate, DLF monetized non-core assets in H1FY13, largely land parcels to the extent of Rs. 920 crore, using the proceeds primarily to reduce outstanding debt to Rs. 244bn in H1FY13, down 3 percent from FY12.

In September 2012, a marginal debt reduction over March 2012, together with annualized EBITDA reducing by 13 percent, resulted in financial leverage increasing to 6.7x after progressively showing a decline in the previous two quarters.

As EBITDA margins appear to be stabilising at levels lower than historically seen, companies will be required to increase sales significantly to reduce leverage.

Liquidity Pressures Ease: Despite slowing revenue, cash flows have turned positive for large companies. This illustrates the efforts by builders to improve their liquidity by adopting a bouquet of strategies – monetisation of non-core assets as well as land holdings, selling plotted developments, exercising prudence in launching new projects and adopting the JV route to develop projects. The JV route prevents cash outflow for land acquisition, as the JV partner is remunerated in built-up space.

Funding Options Limited: The Indian real estate sector will continue to face limited funding options in the near term. In such a scenario, internal accruals will assume significance for funding growth, and companies with revenue visibility from lease rentals will have stable credit profiles.

Banks remain cautious in lending to this sector as reflected in the yoy growth of bank exposure to the commercial real estate sector, which fell to a low of 1.1 percent in September 2012 compared with double digit growth in 2011.Although it recovered to 2.9 percent in November 2012, it remains to be seen whether the trend is maintained.

Private equity inflow into the sector has been moderate: January-November 2012 PE inflow into the real estate sector was 0.7 billion dollars, i.e. 70 percent of total 2011 inflow of USD1bn. (Source: Grant Thornton Deal Tracker). Weak capital markets continue to make initial public offerings (IPOs) unviable. There have been no IPOs in the real estate sector in FY12 and in FY13 till date, and no red herring prospectus has been filed either in these periods.

Other Trends – Joint Ventures: A combination of economic growth and urbanisation will mean that long-term demand for housing will continue and strengthen. Managing opportunities without being trapped by speculative forces is a key challenge for creditworthiness in the industry.

Many developers are using the JV route to develop new projects. India Ratings believes that joint development with land owners, which shields developers from volatile land prices, if used extensively, can be an important contributor to strengthen creditworthiness of developers. Joint development, which allows payment for land through built-up space, allows superior estimation of costs as the builder can plan and control construction costs. Also, the price of land, a key component of overall price, will be subject to market discovery, leading to flexibility in pricing and therefore superior liquidity. Such a development will also significantly reduce stickiness in prices and improve demand.

Developers will continue focussing on affordable housing — with average ticket size of Rs. 2.5m-Rs. 3.5m — and increasingly shift to Tier 2 and Tier 3 cities in the next year. In H1FY13, 68 percent of Sobha’s new launches were in Tier 2 cities like Coimbatore and Thrissur. Over the same period, 30 percent of Unitech’s new launches were in non-metro cities. In H1FY13, 57 percent of DLF’s sales were in Tier 2 cities. While low ticket size projects are being offered mainly by small builders, big builders like Unitech has projects with ticket size ranging from Rs. 25 lakh- Rs. 35 lakh in Chennai, while Puravankara offers affordable housing in the Rs.25 lakh-Rs. 35 lakh price range under its 100 percent subsidiary company – Provident Housing Limited.

2012 Review

In 2012, margins showed signs of stabilising, despite cost pressures. Companies passed on increased costs to buyers, as evidenced from firm property prices. Free cash flows turned positive, as companies adopted various strategies to improve liquidity, such as selling land and non-core assets and judiciously making new launches. Builders focused on affordable housing in the price tag of Rs. 25 lakh- Rs. 35 lakh and continued to diversify into Tier 2 and Tier 3 cities.

While residential demand remained stable, demand drivers remained weak. Commercial demand was adversely impacted by the slowdown in the IT/ITeS sector. Gearing showed some decline as a result of debt reduction, but leverage continued to be high on account of the lower levels at which margins stabilised.